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The Safest Way To Earn High Yields From Emerging Markets
7/8/2013 9:30:00 AM
Over the past few years, I've written repeatedly about the compelling long-term opportunities presented byemerging markets . These economies possess superior long-term growth prospects but trade at a considerable discount to more mature markets in Europe and the United States.
Still, it's hard to understate the importance of "long-term" in that outlook. Emerging markets are quite volatile and can quickly rack up short-term losses. Indeed, in recent weeks a number of emerging markets have tumbled sharply, in large part due to concerns of an economic slowdown in China that is dampening demand for exports in countries such as Australia, Brazil and South Africa. I wrote about theissue in this recent column.
For a while there, global investors were dumping emerging-marketbonds just as fast as they were selling emerging-marketstocks . Then a light bulb went off: Investors realized that bonds are alot safer in a slowingeconomy -- for a pair of reasons.
Those two factors: strong government finances and a lack ofcurrency risk .
Back in the 1970s and '80s, many emerging-market governments showed little competence when it came to managing their finances.Cash reserves often ran dry, and panics ensued. Moreover, emergingmarket finance ministers typically pursued populist spending policies, which eventually led to high rates ofinflation due to poor resource allocation.
Over the past few decades, much has changed. Today's finance ministers often are selected based on their global economic experience, having served stints at places such as theWorld Bank or theInternational Monetary Fund ( IMF ) . These officials now ensure that government cash levels are quite robust, and they take steps to beat back inflation whenever it emerges. Morningstaranalysts note , "Today, many emerging markets have relatively favorable growth outlooks, healthy balance sheets, budget surpluses, and favorable demographics."
A key result: We saw manygovernment bond defaults back in the bad old days, but in the past few decades, Argentina is the only major economy todefault on its bonds. That aspect of risk in government bonds has been virtually wiped out.
Still, U.S. investors suffer whenever the dollar strengthens against other currencies, and that has been a bigfactor in recent losses in emerging market stocks. Bonds don't always carry such currency risk. Many emerging-market government bonds (known as "sovereigns") are denominated in dollars.
Even with a recent rebound, emerging-market bonds have fallen roughly 10% in just a couple of months, which has pushed already impressive yields into high-yield territory. That makes this a fine time to give these three exchange-tradedfunds ( ETFs ) a closer look.
1. iShares JPMorgan USD Emerging Markets Bond (
2. Vanguard Emerging Markets Government BondIndex
ETF (Nasdaq: VWOB)
3. WisdomTree Emerging Markets LocalDebt (
The fund's managers have taken an unusual approach, allocating roughly 40% of the fund to four countries that receive investment-graderatings , another 40% to midtier-rated government bonds, and the remainder in riskier yet higher-yielding bonds. Malaysian, Indonesian, Mexican and Brazilian bonds make up the top four holdings. The 30-day SEC yield of 4.7% nearly matches the iShares JPMorgan ETF noted above.
4. Market Vectors Emerging Markets LocalCurrency
Bond ETF (Nasdaq: EMLC)
Risks to Consider: Emerging-market bonds fell a whopping 30% in 2008, more than twice the current pullback, though that was considered to be a unique economic era that is unlikely to repeat.
Action to Take --> The key distinction between these four ETFs is the currency exposure. Further global economic weakness thisyear could lead to an ongoing "flight to quality " into the U.S. dollar, which would hurt the returns of local currency bonds. But over the longerterm , global trade flows suggest that the dollar is bound to decline over time, which would serve to help boost returns of the bonds denominated in local currencies.